Crude oil has always been an important portfolio diversifier. This historical diversification benefit increased even more in 2009 / 2010. With Federal Reserve Bank of US pumping more money into the system, the crude oil price is likely to head higher which may provide the investors return enhancement besides portfolio volatility reduction in 2011.
Due to inability to invest in physical oil, Investors, both institutional and retail, have shown great interest in the various oil / natural gas based funds. Most of these oil / natural gas funds (ETFs & ETNs) have mandate to track crude oil / natural gas price and invest in paper oil (financially settled contracts). For commodity ETFs and ETNs, the performance in 2009 / 2010 has varied between the precious metals funds (with low tracking error) and oil / natural gas funds which had wide tracking errors (USO & UNG, where cost of storage is significant and where expectation at long end of demand expectation is driving the spot price).
The investors of oil and natural gas funds were disappointed by inability of exchange traded funds to track crude oil price in 2009 and part of 2010. We therefore think that it is important for crude oil investors to analyze the strategy of futures investing which caused this huge tracking error. We compared crude oil price performance to the oil ETFs and three oil stocks indices; integrated oil companies index (PMP Index), exploration and production companies index (EP Index), equipment and services companies index (OSX Index) (index constituents and their weights have been pasted at the end of article for investors interest.).
Oil stocks indices have performed better than US Oil fund (NYSEARCA:USO), US 12 months Oil Fund (NYSEARCA:USL), Deutsche Bank Power Shares exchange traded note (NYSE:DBO) and OLO (NYSEARCA:OLO) in 2009. Relative performance of most of the oil funds (ETFs & ETNs) have improved in 2010 but still underperformed exploration and production and equipment and services oil stocks indices. Integrated oil majors underperformed in 2009 / 2010 because of concentration of downstream and fall out from Gulf of Mexico oil spill.
Some important investing implications for tracking crude oil price in 2011 are;
- The tracking error of US oil funds trended lower in 2010 because of flat crude oil price which reduced negative roll yields. Some of the factors which help flattened crude oil futures curve and reduced US oil fund’s tracking are 1) lower cost of storing crude oil 2) low financial cost 3) lower convenience yield and expectation of rising spot prices.
- As US oil fund invests in front month liquid contracts which are rolled over, it is important to understand the drivers of backwardation / contango in crude oil futures contract market. Crude oil future contracts trade in backwardation in a normal market but in contango in a market fearful about demand.
- Use of any diversification instrument to track crude oil price needs to be dynamic and not static as changing market conditions affect the tracking error of different instruments differently. Rotation into right investment at the right time is important for keeping tracking error low.
- Contango develops in early bull cycle as a result of supply glut / storage and inventory overhang and persists till the time oversupply is not drained or demand expectations do not improve. Contango results in a negative roll yield and sub par performance by front month investors like US oil fund. In an early bull market, equipment and services stocks tend to outperform the other instruments and track crude oil more closely.
- Based on historical performance, crude oil price tracking investors should rotate from exploration and production stocks index into equipment and services stocks index and then into US oil fund by end of 2011 (on expectation of improving market fundamentals). Equipment and services stocks index may outperform other tracking instruments till middle to end of 2011. Exchange traded notes may under perform compared to exchange traded funds in 2011.
- In early stage of a deteriorating market, exploration and production stocks index will track crude oil price more closely compared to other investment instruments.
- Despite atrocious recent performance, US Oil Fund may outperform other crude oil price tracking instruments in late cycle as futures price curve goes into backwardation because of higher financial & storage costs and lower convenience yield. The key drivers of backwardation are that financial and storage cost will dominate convenience yield as well as expectation of rise in crude oil price demand / price. In a backward market (or a lower contango) (flat to inverted futures price curve), roll yield will be positive and US Oil fund may have the lowest tracking error.
Oil / natural gas funds invest in front month futures contracts which are rolled over to the next contract on expiration. Three most important parts of ETF returns are
- Spot Yield: Yield because of spot movement of contract during contracts tenure
- Collateral Yield: Financial return
- Roll Yield : As expiring contracts are rolled over
For USO / USL/ UNG, this very strategy of investing in front month, liquid contracts, in an upwards sloping price curve, has resulted in a negative roll yields in 2009. As crude oil price flattened in 2010, contango relatively flattened out compared to 2009 and performance of US Oil fund improved on relative basis. As we go forward in 2011, if demand picks up and crude oil inventories dip below their 5 years average, USO / USL tracking performance may improve even further.
Contango Vs Crude Oil Inventories: Investors should be watchful of price contango as one of the main drivers of crude oil funds performance in 2011. Contango is defined as price difference between later contracts and earlier contracts and is accompanied by high crude oil inventories. Contango develops when selling crude oil in future is more profitable compared to selling earlier or in spot market. In a normal market, crude oil future contracts should trade at a backwardation – which represents cost of storing crude oil price. For example, high Cushing inventories in Q1 & Q2 2009 resulted in a very sharp contango. Any decline in seasonally adjusted crude oil inventories should result in further decrease in crude oil contango in 2011. Gasoline refining margins, number of miles driven [FHA], refinery utilization rates and OPEC and non - OPEC supply should be watched for US oil fund performance expectation in 2011.
Storage Costs: Other forward-looking measures which may act as drivers for reducing contango are; financial cost of contract, storage cost and spot price expectation. As the cost of storing crude oil and financial cost increase, it should result in decrease in the futures price which an investor is ready to pay.
In the absence of a relevant measure of storage cost, we have used tanker [VLCC] (very large crude carrier (VLCCs) (capacity: 300,000 DWT) storage proxy as tankers were used to store crude oil during the height of supply glut (Q1 & Q2 2009). The benchmark charter rate for VLCC was at US $ 180,000 per day in July 2008 but declined to as low as US$ 5000 per day in February 2009. Currently spot storage prices are in the range of US$40,000 to US$50,000 per day (estimated at US$1.26 / barrel compared to US$3.34 / barrel average in 2007 and US$ 2.42 /barrel in 2009). Storage cost may rise in the second half of 2011 which should help decrease contango.
Financial Cost: With decrease of short term interest rates, financial cost of third month futures contract has trended down from 2007 onwards (against financial cost of around US$1.05 / barrel in 2007, it was only 9 cents / barrel in 2009 / 2010). We expect the financial cost to remain low in 2011 but may increase in 2012 which will further flatten the curve.
Convenience Yield: Convenience yield is the portion of the contract which provides inventory advantage to the commercial users of the contract. Commercial users of the contract lock in at lower future prices which bids up the convenience price of the contract. At the higher future prices, the motivation to lock in for convenience is lower. Convenience yield was US$3.02 /barrel in 2007, US$3.2 / barrel in 2008, US$3.39 / barrel in 2009 and US$2.94/barrel in 2010 and is expected to remain in a tight range between US$ 3 -3.5 /barrel.
Crude Oil Price Expectations: Expectation of rise in crude oil price attracts investors as well as commercial users and averaged US$1.79 / barrel in 2007, US$4.69/;barrel in 2008, US$3.8 in 2009 and US$4.69 / barrel in 2010. This part of contract price is expected to flatten out as short end of the futures price curve may rise more in 2011.
Author's Disclosure: No Positions